The bar to stop hiking is probably lower than the bar to cut rates
Investors have been debating whether the U.S. Federal Reserve's mandate to maintain price stability has been constrained by ongoing concerns about financial stablity. Within this context, what are the implications of the bank's decision to raise rates on March 22?
Following the market volatility that ensued on the back of signs of trouble in the U.S. and European banking sectors, investors paid very close attention to what the U.S. Federal Reserve (Fed) has to say on March 22 in the hope that it could help them gauge whether recent events would affect the bank’s policy decisions moving forward.
Here are our team’s three big picture takeaways from the Fed meeting:
- The market doesn’t believe the Fed’s projected rate path over the next few years. While the central bank's expected terminal rate is now more in line with market expectations, its projected interest-rate path for the rest of 2023 and into 2025 is substantially different from market pricing.¹ Although Fed Chair Jerome Powell noted that the Fed’s base case didn’t include rate cuts, the market's base case certainly does. Who’s right?
- The Fed has incorporated ongoing turbulence in the U.S. banking sector into their deliberations and view recent developments as an alternative form of tightening. According to Mr. Powell, recent developments are roughly equivalent to a 25 basis-point rate hike. He emphasized his belief that financial conditions have tightened more than a lot of traditional financial conditions indexes have indicated. In our view, his message is that if the banking sector were to experience more stress in the weeks ahead, it could reduce the need for that ’final’ hike in this cycle.
- The Fed appeared slightly less concerned about inflation. That said, Mr. Powell was quick to emphasize that there was more work to be done. He noted that long-term inflation expectations remain anchored for households, business, forecasters, and markets. In our view, this is important because if these indicators were to move in the other direction, the Fed could turn hawkish again and the bank’s ability to slow/pause from this point forward might narrow.
We continue to believe that the Fed will be extremely cautious about cutting interest rates too soon, fearing it could trigger a reversal in inflation.
Wednesday’s decision and commentary from the Fed did little to change our views. We continue to believe that the U.S. central bank will be extremely cautious about cutting interest rates too soon, fearing it could trigger a reversal in inflation.
From an investment perspective, we’re likely transitioning into the second phase of our “three-phase approach to investing in bonds”—we think we’re at the point where embracing duration should be beneficial. The tightening of financial conditions over the past week has likely added to the expectation of an upcoming recession, which is typically followed by a drop in yields.
In terms of equities, we believe we’re likely to experience short-term volatility, as the market digests the ongoing fallout from regional U.S. banks and potential price swings in other areas of the market. As the U.S. economy digests last year’s Fed hikes, we believe inflation will continue to trend lower (our base case is that inflation will hit 4% by the end of the year).
Crucially, we expect to see multiple-expansion in the back half of this year (in anticipation of expected rate cuts in 2024), which should help propel markets higher in 2023. As always, we believe stock selection will remain key.
1 Bloomberg, as of March 22, 2023.
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